AP_Krugman_Textbook

Figure 20.4 shows the case of an economy facing a recessionary gap. SRASis the
short -run aggregate supply curve, LRASis the long -run aggregate supply curve, and
AD 1 is the initial aggregate demand curve. At the initial short -run macroeconomic
equilibrium, E 1 , aggregate output is Y 1 , below potential output, YP. What the govern-
ment would like to do is increase aggregate demand, shifting the aggregate demand
curve rightward to AD 2. This would increase aggregate output, making it equal to po-
tential output. Fiscal policy that increases aggregate demand, called expansionary fis-
cal policy, normally takes one of three forms:

■ an increase in government purchases of goods and services

■ a cut in taxes

■ an increase in government transfers

Figure 20.5 on the next page shows the opposite case—an economy facing an infla-
tionary gap. At the initial equilibrium, E 1 , aggregate output is Y 1 , above potential out-
put,YP. As we’ll explain later, policy makers often try to head off inflation by
eliminating inflationary gaps. To eliminate the inflationary gap shown in Figure 20.5,
fiscal policy must reduce aggregate demand and shift the aggregate demand curve left-
ward to AD 2. This reduces aggregate output and makes it equal to potential output.
Fiscal policy that reduces aggregate demand, called contractionary fiscal policy,is
the opposite of expansionary fiscal policy. It is implemented by:

■ a reduction in government purchases of goods and services

■ an increase in taxes

■ a reduction in government transfers

A classic example of contractionary fiscal policy occurred in 1968, when U.S. policy
makers grew worried about rising inflation. President Lyndon Johnson imposed a tem-
porary 10% surcharge on income taxes—everyone’s income taxes were increased by 10%.
He also tried to scale back government purchases of goods and services, which had
risen dramatically because of the cost of the Vietnam War.

module 20 Economic Policy and the Aggregate Demand–Aggregate Supply Model 205

Section 4 National Income and Price Determination

Expansionary fiscal policyincreases

aggregate demand.

Contractionary fiscal policyreduces

aggregate demand.

figure 20.4

Expansionary Fiscal Policy Can

Close a Recessionary Gap

AtE 1 the economy is in short -run macroeco-

nomic equilibrium where the aggregate demand

curve, AD 1 , intersects the SRAScurve. At E 1 ,

there is a recessionary gap of YP−Y 1. An expan-

sionary fiscal policy—an increase in government

purchases of goods and services, a reduction in

taxes, or an increase in government transfers—

shifts the aggregate demand curve rightward. It

can close the recessionary gap by shifting AD 1

toAD 2 , moving the economy to a new short -run

macroeconomic equilibrium, E 2 , which is also a

long -run macroeconomic equilibrium.

Aggregate

price

level

E 2

E 1

LRAS

SRAS

AD 1

AD 2

P 1

P 2

Y 1 YP Real GDP

Recessionary gap

Potential

output